In today’s post, we will continue our series on why people fail financially. Today we will talk about tax laws and how common it is to fail due to misunderstanding tax laws.
Misunderstanding Tax Laws
“Over and over again courts have said that there is nothing sinister in so arranging one’s affairs as to keep taxes as low as possible. Everybody does so, rich or poor; and all do right, for nobody owes any public duty to pay more than the law demands: taxes are enforced exactions, not voluntary contributions. To demand more in the name of morals is mere cant.” (Commissioner v. Newman, 159 F.2d 848, 851 (2d Cir. 1947) – dissenting opinion.)
Yet we see very little effort to reduce taxes in advance of when taxes are due. Attempting to do this at tax time (during preparation) is futile. Tax preparation is not tax planning. Tax planning is a major area of failure for most people. It is often overlooked and can change your lifestyle.
A Real-Life Example
Let me share a real-life story from one of my former clients (the names are changed to protect the innocent). It is the story of Gary and Susan— two public servants who were in their late 20’s or early 30’s. During a complimentary consultation, they explained to me that they were into debt up to their eyeballs, that they wanted to start a family, and eventually that Susan would be a stay-at-home mom. I explained that this advice does not come cheap and that they may not get any short-term value in comparison to the planning fees I would charge. Gary said he didn’t care that the cost may be greater than the reward now. He wanted to go through the process. If the advice was not helpful now, it would have value in the future. I couldn’t argue with that.
As part of the process, I needed to gather accurate financial information about the clients’ finances. So I calculated all of their income and all of their expenses and found a discrepancy of $10,000. In other words, I calculated all their yearly income and all their yearly expenses, and they were $10,000 short! Well, I started wondering if there was a mistake. I went over the numbers again and again. I reviewed this with the clients, and both had absolutely nothing to say. Finally, I said, “Look, I’m gonna take a break and run and go to the men’s room for a few minutes. When I return, I need to know what you’re not telling me. If you don’t, well, unfortunately, we are gonna have to end this relationship. We cannot build a financial plan on false or incorrect information.”
What Were They Hiding?
I left the room thinking that there must be drugs, or another woman, or another man. It was getting crazy, and it was driving me crazy. What could it be? I walked back into the meeting room and found Gary’s head hanging down. I thought, “Oh, boy, here it comes.” Gary then proceeded to tell me about his garage. He has been moonlighting to make some extra money by fixing and painting people’s cars. And he was restoring a vehicle which he purchased. He had been spending lots of money on the restoration and had not told Susan.
So to make a very long story a little shorter… as I suspected, he did not document any of the expenses or income on the autos he repaired. He had been running a repair business out of his garage for the past three years. He simply didn’t know he could write off all the expenses related to that business. Because he was a police officer, he thought it best just to keep it quiet. He simply was misunderstanding tax laws.
With the new information in hand, I made a tax recommendation to file amended returns for the past three years. We made sure to take deductions for the use of the garage, cell phones, office expenses, the new equipment that was purchased, depreciation of existing tools, paint, etc. These tax refunds were large enough to pay off all their credit card debt and loans. Gary’s credit score went through the roof, and he was able to refinance his home to a lower interest rate, making smaller payments. Without those monthly credit card payments and with a lower mortgage payment, they finally had a substantial positive monthly cash flow.
A Chart of Explanation
Below I created a chart to compare the same amount of money earned as an employee vs. as self-employed. Remember, this is 2017-2018 Tax law, and if there is anything I learned about taxes, it is that they are always changing. So either study the code while in custody or find a competent tax planner/preparer upon your release.
|W-2 Salary||1099 Contractor
|Social Security or Self-Employment Tax||($7,650)||($15,210)|
|SE Tax Deduction||$0||($7,605)|
|20% Pass-Through Deduction||$0||($17,608)|
Please take note of the term Gross Income. This is the result of all your business income less all of your business expenses.
When you’re an employee, in most cases, your cell phone expenses will not be deductible. When you are in business for yourself and using it for your business, it will be deductible. Your home computer for personal use, in most cases, is not deductible. But when it is used for business, the computer and related expenses are all deductible from that Gross Income, and that lowers the Taxable Income number. The lower the Taxable Income, the lower your taxes will be. This is the black and white tax law. So unless you have a blessed job, paying lots of money and with lots of benefits, consider becoming self-employed or an independent contractor.
Lastly, most of you may have tax returns that have not been filed. DO NOT WORRY!!!!! The IRS, believe it or not, is a very open-minded group. Good faith and honesty go a long way here. The key thing is to communicate with them. It’s not easy, but you must communicate. Share your story, and they will give you affordable alternatives—and they have lots of them. Then, just stay current on all the new stuff going forward, and it’s all good. The key here is to be sure that you are not misunderstanding tax laws.